19-02-2017

Financial Management
Bond Valuation

Chapter 3
48-53, 62-70

Bonds: Nomenclature
10%, 2022 GOI Security (G-Sec)

Par Value or Face Value

Redemption Value or Maturity Value
Maturity Date (Term to Maturity)
Coupon (coupon rate)
Yield to Maturity

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Types of Bonds
Plain Vanilla Bond
Bonds with Call and Put options
Convertible bonds
Floating rate bonds
Inflation Indexed Bonds
Zero-coupon bonds

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Call and Put Options

A call option gives its owner the right to BUY an asset at a specific price.
Suppose, I sell you a Call option on one share of HUL. You have the right to buy the stock
from me anytime in the next 1 month by paying me Rs.900. The stock is currently trading at
Rs.849.
A put option gives its owner the right to SELL an asset at a specific price.
Suppose, I sell you a Put option on one share of HUL. You have the right to sell the stock to
me anytime in the next 1 month at Rs.900.

Inflation Indexed Bonds

The payments on these bonds are tied to the rate of inflation. The coupon rate on
such bonds are real rates.
Known as Treasury Inflation Protected Securities (TIPS) in U.S.
An example:
The par value of the bond is $1,000. Coupon rate is 4%. The bond has 3 years to maturity.
Suppose the actual inflation rates are 2%, 3% and 1% respectively in the next 3 years. How
much return the investor earns?

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Inflation Indexed Bonds Calculations

Warren Buffets Bond

Negative coupon bond

Face Value of Bond = $1000 (assumed)
Coupon Rate = 3%
Holding Charges = 3.75%
You get the right to buy the share at $89585 per share
Market Price on Issue Date = $77900

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Yield to Maturity
ABC Limited issued 10%, 2018 bond last year.
Government of India was borrowing at 6% last year.
Now the risk free rate of return has decreased from 6% to 5%.

Yield to Maturity

XYZ Limited issued 7%, 2018 bond three years

back. At the time of issue of the bond, its rating
was AAA. Now it has deteriorated to AA-. Now
AA- rated bonds are paying 9%.
Assume that the risk-free rate has not changed in
between.

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Determinants of YTM

YTM = Risk-free rate + Default Spread

CORPORATES
0.5 1 2 3 4 5 6 7 8 9 10 15
AAA 100 101 91 67 60 53 41 48 58 56 48 16
AA+ 113 112 100 74 67 60 50 58 70 70 64 40
AA 142 139 122 94 86 79 69 79 93 96 92 75
AA- 173 171 156 129 122 115 105 115 128 130 126 111
A+ 200 199 186 161 156 152 144 155 169 172 168 142
A 232 231 219 195 191 187 180 192 207 211 207 173
A- 275 276 267 244 239 234 225 235 247 247 241 210
BBB+ 309 312 306 285 281 277 267 275 286 285 277 245

Source: http://fimmda.org/modules/bonds/corporate-bonds.aspx?m=btd: Accessed on

27 December, 2015

Yield to Maturity
Meaning of YTM
Factors affecting YTM

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Bond Valuation Model

F = Face Value
C = Annual Coupon Payment
c= annual Coupon Rate
N number of Years
Y = Required Yield

Bond Valuation Equation

C C CF
Pr ice ...
1 Y (1 Y ) 2 (1 Y ) N
C/2 C/2 C/2 F
Pr ice ...
(1 y ) (1 y ) 2
(1 y ) 2N
(1 y ) 2 N

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Time Path of a Bond

Consider a 12% bond maturing on 1 January 2020. Today we are on 1
January 2017.
The bond is trading at a yield of 10% APR.
Coupons are paid annually. The next coupon is due exactly after one
year.

Time Path of the Bond

What will be the value of the bond on 1 January 2018 immediately
after the coupon payment if
The yield is 10%
The yield is 8%
The yield is 12%
The yield is 14%

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Time Path of the Bond

What will be the value of the bond on 1 January 2019 immediately
after the coupon payment if
The yield is 10%
The yield is 8%
The yield is 12%
The yield is 14%

Chapter end problems

Q1 Q5 (skip part 2 of Q4)

Q10, Q14, Q15 Q17
Q28 Q31